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walking the dog

Stochastic Trend Following Strategy

Stochastics is one of my top indicators. It is useful for making several different types of technical analysis, the one I am going to discuss today is trend following signals.  Trend following signals are one of the best types of signals that this indicator gives and one that can be highly profitable for binary traders.  I prefer to trade trend following signals because they are more reliable. This may sound redundant as most trading educators will tell you that “the trend is your friend and you should trade with your friend”. Well, it is and it is true. The power of the trend is without equal in trading.

What Is Stochastic

Stochastic is a unique indicator in that it assumes that the shorter term movements of an asset are random and cannot be predicted.  It is based on random walk theory and Brownian motion. Whereas the short term fluctuations are random, over time those random movements can be plotted in a way that predicts overall direction. It’s like this; Imagine a man walking a dog, the dog may pull the man side to side as it moves on the leash but the man controls the over all direction the two are moving in. In this analogy the dog is the short term random day to day movement of the market where the man represents the longer term trend. No matter how strong the day to day gyrations of the market (the dog) pull against the trend (the man), the trend still leads the market higher.

  • Stochastic oscillator uses two lines, %K and %D. The %K line is calculated and then smoothed with a moving average to produce the %D line. Signals can be taken in a variety of ways including crossovers, convergences and divergences. Click here for more on using stochastic to trade binary options.

stochastic dog and man

What Is The Trend?

The trend is the general direction of the market. It will either be up, down or sideways.  Sometimes an asset will trend strongly, that is it will visibly move higher on your charts. Sometimes it will trend weakly, becoming visible as different technical analysis techniques are applied. I will describe two methods of determining trend that can be used with this strategy. First will be the visual method, for the second I will tell you how to use stochastic and time frame to determine trend.

Visual Trend Determination – Visual trend determination can be done with the naked eye. Two things that make it easier is experience and a strong trend. Otherwise you will need to use trend lines. Trend lines connect consecutive peaks and troughs on an asset chart. A series of higher peaks and troughs equals an uptrend, a series of lower peaks and troughs a downtrend.  If the peaks and troughs do not trend higher or lower then the trend is said to be sideways or range bound.  Stochastic trend following signals work better in an up or downtrend but can also be used in a sideways market.

Using Stochastic To Find Trend – Stochastic can be used to find or to confirm trends. Stochastic confirms a trend when it is making higher peaks along with an asset that is making higher peaks, or lower peaks as the case may be.  If stochastic is confirming a trend you can take a signal whenever stochastic is pointing in the direction of the trend. This is what I mean; if you have a visual up trend and stochastic is confirming it you can take a signal whenever stochastic makes a new trough and then points up.

  • A series of higher peaks and troughs, or lower peaks and troughs, indicates trend the same as they would if presented on the price chart itself. Notice on the right hand chart below how the %D line makes a series of higher troughs coincident with the asset.
Using stochastic to find trend.

Using stochastic to find trend.

Using Time Frames For Trend – You can also use different time frames to determine trends with stochastic.  To do this you will need to use two different time frame charts, I like to use the weekly/daily or daily/hourly combination depending on the asset. Weekly/daily works well with stocks and indices while I prefer the shorter time frame for currency and commodities. This is how it works; stochastic on the longer term chart sets trend, stochastic on the shorter term chart gives the signal. If, on the weekly chart, stochastic is pointing up then you would trade bullish signals on the daily charts. Or if using the daily/hourly combo the stochastic on the daily would set trend while signals would come from the hourly chart.

  • Match stochastic in different time frames to determine trend. If stochastic is pointing or trending up in a longer time frame then bullish stochastic signals can be taken in a shorter time frame. Look at the chart above. On the left hand side, weekly data, the asset formed a bottom between November-February with a bullish stochastic crossover setting the trend. On the right hand side, daily data, bullish signals are taken for short term trades.

Stochastic Trend Following Signals

Weak Signal/Strong Signal – This technique will give off at least three signals that I regularly follow. The weak signal, the strong signal and the continuation signal. The weak signal is always the first one you will see. It takes a lot of practice to be able to capture this signal and profit consistently but the good news is, it is almost always followed by the strong signal. The weak signal is when the indicator first changes direction to return to the underlying trend.  This signal usually takes longer to develop into profits so I use longer expiry with this one. A signal on the daily charts may take 1-3 weeks to move into the money whereas a signal on the hourly charts may take a few days or a week. For the daily signal, use a one month expiry, for the hourly use one week.

usd-jpy strong stochastic signal

The Strong Signal – The strong signal comes after the weak signal, in fact, there is no strong signal without the weak signal. This is good news because if you did not catch the weak signal you can still get in with the strong one. The strong signal occurs after the market moves on the weak signal, retests support and then moves higher again. This causes a comparable dip/retest on the indicator as shown in the picture below.  Strong signals usually develop into profitability much faster so I use a much shorter expiry. For signals on the daily charts one week is usually perfect while on the hourly charts end of day or end of tomorrow works very well.

strong stochastic signal

  • The strong signal always happens after the weak signal. The strong signal confirms support and is usually accompanied by a coincident signal in the asset. Look at the chart above. At point 1 the weak signal is given. At point 2 the strong signal is given, notice how at point 2A the asset is making a similar confirmation of support and then moves higher.

The Continuation Signal – Once the asset is trending on the strong signal it is time to look out for possible continuation signals. This will be a dip or ripple in the stochastic indicator similar to the strong signal but occurring after the move has begun.  It could also occur after a near term pullback. Look at the chart above.  After the strong signal has fired the asset moves higher until it reaches over bought status. The asset keeps trending higher but the %D crosses below and then back above the %K line forming a continuation signal.

  • Once the strong signal has been given and the asset is moving higher any time that the %D dips or crosses below the %K line and then points back up can be considered a continuation signal. If both lines are pointing in the same direction (up in an uptrend, down in a downtrend) the signal is stronger than if not. Look at the chart above. At point 3 the asset has dipped below the %D and then crossed back above creating a continuation signal.

Support and Resistance With Stochastic

Support and resistance are great additions to this strategy. For one, if your signal is developing while the asset is testing or confirming either support or resistance it is a much strong signal than if not. For another, if your signal fires and there is a resistance level close by it may adversely affect your trade. Knowing where these areas are in relation to the asset price and stochastic is a really good way to weed out false signals and potentially bad trades.

  • I use support and resistance with stochastic to create strong signals. I draw my own lines and also use the Fibonacci Tool available with most charting packages. If my stochastic signal forms and confirms a support or resistance it is a stronger signal than if it forms on its own. Likewise, it takes more than an asset to reach or even bounce off a support or resistance line to create a strong signal.  If you look back at all of the charts I have presented here today you will notice that each of the strong signals was confirming support of some kind. Support could be a moving average, support line, trend line, Fibonacci, Bollinger Band or many many other forms of technical analysis.

I have another article about using support and resistance in trading. It is a great addition to this technique and one I highly recommend.